Heading for a brick wall

Can future housing bubbles be prevented?

IF SOMEONE had told you three years ago that share prices in America and Europe would plunge by almost 50%, you would have braced yourself for a deep global recession. One reason why many economies have held up better than expected is that rising house prices have offset the loss of equity wealth and so helped to support consumer spending. Indeed, in America housing is arguably the only remaining prop for the economy. But by keeping interest rates low to cushion the economy from a slump in share prices, some central banks may have inflated a housing bubble. America, Australia, Britain, Ireland, the Netherlands and Spain look most at risk.

Yet even as house prices start to wobble, many housing experts continue to insist that “this time is different”: because interest rates will not rise significantly in the near future, they say, a slump in house prices is unlikely. This survey has argued that even if interest rates stay low, house prices could tumble, undermined by dwindling demand from first-time buyers and waning confidence. However, the experts are right to say that this housing boom is different from previous ones, in two worrying ways. First, inflation today is close to its lowest for half a century. This means that overvalued house prices cannot regain their long-term equilibrium mainly through inflation, as they have done in the past. Instead, house prices will have to fall by at least 20% in money terms in most of the countries with bubbles.

A second important difference is that this time the surge in house prices has gone hand in hand with a proportionately larger jump in household debt. Not only are new home-buyers taking out large mortgages as a percentage of the purchase price, but existing owners have taken advantage of rising house prices to increase their mortgages and turn some of their capital gains into spending money. In America, Britain, and Australia mortgage-equity withdrawal is running at record levels of 5-7% of personal disposable income.

A bubble can never be positively identified until after it has burst, but the rapid increases in both house prices and mortgage debt should set alarm bells ringing. Either way, consumers are living on borrowed time. Even if house prices simply flatten off, the scope for mortgage-equity withdrawal and hence consumer spending will slow sharply. If, as seems more likely, house prices fall, the recent borrowing binge means that more people than ever before will find their homes are worth less than their mortgages.

Prepare for impact

Even those with a small mortgage will be hit, because for most people their home is by far their most important asset. In particular, a sharp fall in house prices will be another blow to those about to retire. Their pensions have already been battered by the stockmarket crash, and if they were planning to supplement them by selling a home or by taking out an annuity against it, they will find their nest-egg is worth less than they had expected.

A fall in house prices would also lead to a rise in mortgage defaults. In the past, the biggest victims from a housing bust, other than the borrowers themselves, were the banks and savings institutions. Today American banks sell mortgages in the secondary mortgage market, mainly to two government-sponsored agencies, the Federal National Mortgage Association (affectionately known as Fannie Mae) and the Federal Home Mortgage Loan Corporation (Freddie Mac), which finance their purchases by issuing bonds or by pooling mortgages and selling them as mortgage-backed securities. This has allowed banks to make even more housing loans, helping to fuel the bubble.

This time the banks themselves are less exposed to a property bust, but the sheer size of Fannie Mae and Freddie Mac (which at the end of 2002 accounted for 44% of all mortgage debt) could pose a risk to the whole financial system. If house prices fell, some of the mortgages they hold in their portfolio could go into default and they would not have enough cash to pay the holders of their bonds. The agencies' debt is priced as if it were guaranteed by the government, yet there is no explicit guarantee, so it is not clear whether the government would bail them out in a crisis. A default on their bonds would have serious knock-on effects because mutual funds, banks and savings-and-loans institutions are all large holders. But the cost of a bail-out could dwarf any previous ones.

If the housing bubbles burst, the economic consequences will be much more severe than those of the recent stockmarket crash, because more households own homes than own shares, and because home-owners are up to their necks in debt. Ominously, Japan's property-price bubble burst a couple of years later than did its stockmarket bubble, and the massive wipe-out of wealth that resulted has been partly responsible for a decade of economic stagnation. Many will argue that Japan was an exception. There are certainly differences, notably that Japan's banking system was in a much worse state to start with. But there are also some similarities. The most worrying is that with interest rates already close to zero, America's Fed now has little room left to cut interest rates if the economy were to run into trouble. A housing bust might therefore nudge the economy into deflation.

Shoring up the foundations

If the housing boom ends badly, policymakers will need to draw lessons about how to reduce the risk of future bubbles. A first requirement is the provision of better data on house prices, rents and new construction to improve market transparency. In most countries the most up-to-date statistics are collected by private-sector lenders or estate agents, who tailor data to their own needs. Official statistics offices typically collect more information about the price of shoes or cement than housing, despite its far greater economic importance.

A second requirement is for more research on what drives house prices, why prices are more volatile in some countries than others, and what effect changes in house prices have on consumer spending. Traditionally, economists have found property a less glamorous subject than stockmarkets. It is certainly less financially rewarding, because investment banks have traditionally had little interest in it. That will have to change.

A third lesson is that central banks should sometimes tighten monetary policy in response to sharp increases in asset prices even if inflation is low. Central bankers' fixation on consumer-price inflation in recent years has blinded them to other important signs of financial and economic imbalance. They have ignored the build-up of excess liquidity, which instead of pushing up inflation has spilled over into asset markets: first the stockmarket and now housing.

It is true that if the Fed had not slashed interest rates after the stockmarket collapsed, the downturn would have been much steeper. But by inflating a house-price bubble and encouraging households to borrow more, the Fed has merely delayed the day of reckoning. With households now even more deeply in debt, a fall in house prices would have even more serious consequences.

As an alternative to raising interest rates to curb a housing bubble, governments could discourage excessive borrowing by limiting the size of a home loan as a proportion of the purchase price. Not only would this help to prevent home-buyers ending up with negative equity if prices fell, it could also help to moderate booms and busts. The maximum size of a loan could be reduced when house prices are rising rapidly, helping to cool the market, and raised in a downturn.

Some analysts have blamed the boom-bust tendency of housing markets on the tax reliefs that home-buyers in many countries enjoy. It may be no coincidence that some of the countries with the most generous tax breaks on buying a home—the United States, Spain, Ireland and the Netherlands—have recently seen strong house-price booms. Yet so has Britain, which phased out tax relief on mortgage interest some time ago, so that cannot be the whole explanation.

Gordon Brown, Britain's chancellor of the exchequer, has now developed different ideas on how to make house prices less volatile. He puts some of the blame on the variable-interest-rate mortgages currently in widespread use in his country, and wants to convert borrowers to long-term fixed-rate mortgages, as widely used in continental Europe and America.

Mr Brown is right to want to shift home-buyers to fixed-rate mortgages if he expects Britain one day to join the euro, because such a shift would reduce the sensitivity of the whole economy to interest-rate changes. It would not, however, prevent housing booms and busts. Just look at Japan, where 30-year fixed-interest mortgages prevented neither the emergence of the housing bubble nor its popping a decade ago. In Britain, a more important reason, perhaps, why house prices are so volatile is that supply is less responsive to changes in price than in many other countries, partly because of planning regulations. If policymakers want to even out booms and busts, they need to ensure that supply responds more promptly, as well as raising interest rates to dampen demand earlier in the cycle.

So much for lessons for policymakers; what advice is there for home-buyers? Anyone thinking of buying in any of the housing markets that this survey has identified as bubbling should wait until prices have fallen. Anyone who already owns a home but has to move for work or family reasons should consider selling and renting until prices drop. Most home-owners, however, will have to stick it out and watch their wealth dwindle. Their mistake was not to buy a home, because they can still enjoy living there. Where they went wrong was in expecting double-digit returns to continue, and to make decisions on that basis, such as taking out a second mortgage to support a more lavish lifestyle, or neglecting to save for retirement. In a world of near-zero inflation, double-digit returns are no more sustainable on houses than on equities. Next time an exuberant estate agent tells you that bricks and mortar are the safest thing you can invest in, hit him on the head with this copy of The Economist.